Tuesday, August 26, 2014

A look at the coming 30-year inflation cycle

The upcoming bottom of the 60-year cycle will drastically alter the U.S. economic landscape.  The ending of the long-term disinflationary/deflationary undercurrent will soon give way to a new long-term cycle of re-inflation/inflation, bringing with it both challenges and opportunities.

As we begin a new 60-year cycle, the main challenge for the Federal Reserve will be to resist the temptation to stimulate the economy during periods of sub-par growth.  The saying, “Old generals fight the old wars” applies here as the Fed has always had difficulty in discerning the dominant economic undercurrent. 

For instance, from the 1980s onward, most Fed presidents have had an abnormal fear of inflation after the harrowing experience of the 1970s.  Only in the years following the credit crash has the Fed concentrated on fighting deflation.  After the unforgettable experience of 2008, it doesn’t take much imagination to see the Fed fighting the specter of deflation for years to come, long after deflation ceases to be a threat.

If the Fed remains true to form we can probably expect to see a continued commitment to a fairly loose monetary policy in the first few years of the new 30-year inflationary cycle.  The good news is that it will still likely be several years before significant inflationary pressures come to bear.  In the years immediately ahead we should see an increasing volume of the excess cash on the sidelines returning to circulation.  This will result in a gradual rise in inflation, though it shouldn’t immediately result in runaway inflation.  The second half of the 30-year cycle in the years 2030 through 2044 is when hyperinflation will likely become an issue.

The following graph is a stark reminder of the deflationary undercurrent of the last several years.  It shows the velocity, i.e. turnover, of money in the U.S. economy.

At some point the velocity of money will reverse its long-term decline as confidence increases and investors realize that the threat of deflation has disappeared.  Will the hundreds of billions in sidelined money enter the economy as a slow, gradual trickle?  Or will it re-enter the channels of commerce quickly as a mighty onrushing torrent?  Since no one can definitively answer this question, the wisest policy would be for the Fed to resist the temptation to employ money printing schemes as a palliative for boosting the economy, especially as this will be unnecessary in the years ahead. 

In his March 11, 2009 “Special Edition VII” entitled, “Terminal Opportunity 2009,” Samuel J. Kress described the 60-year cycle as the primary bias or “Super Cycle,” with the 30-year cycle being the half-component of the 60-year cycle, also known as the secondary bias cycle.  Kress wrote:

“The 60-year [cycle] correlates to the average duration of the underlying economic ‘super cycle’ which ranges from 40-80 years.  This cycle was identified in the early 1900s by a Russian economist, Nikolai Kondratieff, which tracks wholesale commodity prices, and being void of any value added, it represents real demand in the economy.  Additionally, it indicates the boom/bust phase of the credit/debt cycle.  Being variable in duration, it is more appropriately referred to as the K Wave.  It includes four (completeness) economic seasons: spring, summer, fall, winter.” [Special Edition VII, Terminal Opportunity 2009, p. 2]

The chart example labeled “60 Year Super Cycle” is an illustration from a past Kress Special Edition and delineates the phases of the 60-year cycle.  It is broken down into four 15-year segments which are known as economic “seasons.”  The following graph correlates each season to its appropriate inflationary or deflationary aspect over the previous 60-year period from 1954 through 2014.

The first 15-year segment of the 60-year cycle is characterized by re-inflation; the second 15 years typically sees increasing inflation or even hyperinflation.  The next 15-year segment sees disinflation or early deflation, and the last 15-year segment is the deflationary phase.  Each 15-year segment of the 60-year cycle is assigned a “season,” e.g. winter, spring, summer, fall.

Is it possible that the years immediately ahead could see above-average inflation?  The answer is yes, but only if there’s an unusual dynamic in place.  An example of an unusual dynamic would be the outbreak of a major war.  War is always inflationary for commodity prices and would only serve to heat up the economy faster than the new 30-year inflationary cycle would do on its own. 

Following the 60-year cycle bottom of 1774, for example, inflation was a major problem in the colonies during the U.S. Revolutionary war in 1777-79.  At that time a pound of butter cost $12 a pound while flour fetched nearly $1,600 per barrel in Revolutionary Massachusetts.  Keep in mind this was only 3-5 years after the long-term Kress cycle bottomed.  Jason Zweig observed that inflation was also a major problem during the U.S. Civil War.  During the war years in the early-to-mid 1860s, “inflation raged at annual rates of 29% (in the North) and nearly 200% (in the Confederacy),” he writes.  He also points out that immediately following World War II, inflation hit 18.1% in the U.S.

Turning our attention to the stock market, many analysts have taken up the theme that another major correction or even a crash is just around the corner.  The thinking behind this is that the stock market rally of the last five years artificially induced through the Fed’s monetary stimulus.  Under the bears’ theory, once QE completely ends the markets will experience a major re-valuation and a return to a “normal” price level. 

In response to this scenario, an observation can be made that the market is already back to “normal.”  Consider that equities, which desperately wanted to rally in the years between 2004 and 2007, were held back from realizing their full potential by the tight Fed policy of the time.  The Fed’s interest rate policy of 2004-2007 did the economy no favors and was one of the catalysts behind the credit crash of 2008.  When finally the Fed got its investment rate policy back in alignment with the long-term cycle, the market quickly returned to its proper level as the economy recovered. 

Consider, too, that we’ve come through a tumultuous 15-year period which saw two major bear markets, the constant threat of terrorism, a two-front multi-year war, and the near-collapse of the U.S. economy.  The years between 2000 and 2014 can therefore be described as an elongated “correction” in the super long-term uptrend in America’s progress.  A few years ago there was a question as to whether or not the economy would survive the upcoming 60-year cycle bottom.  With hindsight it’s now obvious that the last 15 years of the cycle – the deflationary phase – was cleansing and restorative rather than ultimately destructive.

There is every reason for believing the next few years of the new 60-year cycle will be as salutary to the economy as the previous 15 years were depressive.  A new economic spring season will soon follow the economic winter of the last several years.  With the coming of long-wave spring we should see increasing signs that the economy is returning to a normal, healthy rate of growth.  The fear and uncertainty that were prevalent in the last 15 years will gradually subside and be replaced by rising confidence as investors and businesses take more chances and spend more money into circulation.  The rising tide of long-wave spring will lift all boats as a greater segment of America’s social classes begin to experience an economic rebound from the depressing years of the winter season.

At long last, it’s time to bid the 15-year economic winter adieu and welcome the onset of spring!

Thursday, August 21, 2014

Deflation’s final curtain call (part 2)

As the 60-year cycle enters its final few weeks of descent, a few conclusions can be made.  We can also make some projections as to what the foreseeable future might hold based on the upcoming bottom of this important economic cycle.

Since the 60-year cycle is the primary cycle governing inflation and deflation, it makes sense that its impact will be most strongly felt in the prices of inflation-sensitive commodities.  Its force is also evident in wages, interest rates, and other factors which influence the general course of the economy.  One of the biggest areas affected by the cycle is in earnings and income growth. 

The graph below shows the year over year change in total earnings in the U.S. since the 1960s.  The peak in earnings on a percentage change basis occurred around the time of the last 60-year cycle peak in the early 1980s.  After the plunge of the 1980s, earnings growth for production and nonsupervisory workers has never come close to regaining the peak from 30+ years ago.  This exhibit provides some context for the influence of the economic long-wave and the economic trends it generates. 

Many observers have noted the disparity of fortunes in recent years between the upper and lower classes within the U.S.  The recovery of the last five years has unquestionably benefited the upper class (the so-called “1 percent”).  The massive rebound in equity prices has helped the rich much more than the middle class due to the increased exposure to the stock market enjoyed by the former group.  The middle class by contrast has seen its fortunes wane since the crisis years of 2007-2008.  This is due in part to the middle class’s lower exposure to equities and can also be attributed to the lack of wage growth. 

Another important reason for the lack of a strong rebound in the middle class economy can be seen in the following graph. 

The above graph shows the expenditures of the federal government going back the last several years.  Following a brief spike in government spending in the post-credit crisis period, the rate of change in expenditures plummeted and has never quite recovered to its much higher historical average.  This is one of the key reasons why the middle class economy has been relatively slow to recovery since 2008. 

During the last five years the middle class has seen its tax burden rise along with cost of living increases, yet there has been no commensurate rise in services provided.  In other words, the government has continuously taken from the pockets of the working class without giving back in the form of direct spending, such as infrastructural repairs, contract building, etc.  This refusal to spend by the government during a time of acute crisis for the middle class is effectively an austerity policy.  Government has persistently focused on lowering the budget deficit in recent years by raising taxes and through forced spending (e.g. Obamacare) instead of cutting taxes, which paradoxically would have increased government tax receipts through the higher levels of consumer and business spending it would have engendered. 

What we have witnessed during the past five years has been a dual fiscal and monetary policy of both austerity and stimulus: government fiscal policy has been austere while central bank monetary policy has been liberal.  The net result of this conflicting set of policies has been to force the brunt of the deflationary 60-year cycle upon the middle class while shielding the moneyed classes from its effects. 

Indeed, the Fed’s loose monetary policy known as QE has all but blunted the impact of the final deflationary leg of the 60-year cycle for the financial sector.  Equity prices were largely exempt from the final 5-6 years of the deflationary long-wave.  The 2008 credit crash was essentially the “super crash” that many long-wave analysts were calling for.  It arrived a few years ahead of schedule but was still within the final “hard down” phase of the 60-year cycle (defined as the last 10 percent of the cycle’s duration).  The recovery since the 2008 super crash was fierce and unprecedented, thanks largely to the scope and scale of the Fed’s intervention.

Now that the 60-year cycle is winding down we can see the last vestiges of its deflationary pressure in certain inflation-sensitive commodities.  The crude oil price has been in decline since June, as you can see in the following graph.  Since a wide range of retail consumer prices are based on the oil price, the lower the price of oil goes, the better it will bode for the retail economic outlook entering 2015 once the new 60-year up-cycle kicks off. 

Monday, August 11, 2014

Q&A on the Kress cycles

Q: Is it possible that the Fed has postponed the 60-year/120-year cycle bottom through QE? 

A: Mr. Kress always maintained that his cycles were fixed, that is, unchangeable in time.  To him, the 60-year cycle scheduled to bottom in the fall of 2014 would bottom right on schedule regardless of what the Fed was doing to prevent it.  In the many years of constant correspondence I had with Bud Kress, I believe he underestimated (with all due respect) the power of the Fed in mitigating the long-term deflationary cycle.  I agree with him that the Kress cycles are absolutely fixed and that the upcoming 60-year cycle bottom this fall will indeed represent the bottom of the long-term deflationary cycle.  That doesn’t necessarily preclude a future bout of temporary deflationary pressure, however, in response to the Fed’s continued intervention efforts. 

I believe a more accurate way of describing the impact the Fed has had on the 60-year cycle is that its ultra-loose monetary policy has cushioned the blow of deflation.  Instead of runaway deflation, we experienced only a few sporadic bouts of deflation between 1998 and 2008.  Retrospectively, the previous 120-year cycle bottom of 1894 was also relatively benign.  This shows that deflationary “winter” seasons can be mild depending on the extent of monetary conditions.

Q: Have you changed your stance on the upcoming 120-year cycle bottom?

A: As for the equity market, while it’s true that the long-term Kress cycles are due to bottom in late September the zero interest rate policy (ZIRP) of the U.S. Federal Reserve has kept the stock market unexpectedly buoyant.  I still think we may see a correction in the equity market by later this summer before the late September/early October cycle bottom, but at this point the scenario envisioned by Kress isn’t likely to occur.  Weakness in equities has actually been bullish for gold and mining stocks this year, so perhaps the gold sector will escape the selling pressure should we see a decline in equities in the next couple of months.

In retrospect it appears that the super crash predicted by Kress was the 2008/2009 crash.  This crash occurred during the final “hard down” phase of the 60-year cycle (defined as the final 10% of a cycle’s duration).  Ten percent of 60 = 6, and if you subtract 6 years from 2014 you get 2008.  Therefore I think it’s evident now that the 2008 credit crisis was the effects of the Kress Mega Cycle being felt early, but still within the allotted “hard down” phase.  This is what Bud Kress would have called a “bottom in price before a bottom in time.”

Friday, August 8, 2014

Deflation's final curtain call

Gold has once again begun to assert its safe haven value after the recent drop in equity prices.  Last week’s Argentina bond default scare coupled with rising tensions between Russia and Ukraine have combined to spook global equity markets. 

On Thursday NATO warned that Russia was preparing to send 20,000 troops into eastern Ukraine under the pretext of a humanitarian mission to save separatist rebels.  Due to these concerns gold’s value has risen to a 2-week high.  Gold’s rally is all the more conspicuous in light of the recent rally in the U.S. dollar index.

Adding to gold’s growing attraction as a safe haven was Thursday’s decision by the European Central Bank (ECB) to leave the benchmark interest rate unchanged at record lows.  This was preceded by news on Wednesday that Germany experienced a second monthly decline in factory orders (-3.2% versus an expected +1.0%, according to Briefing.com).  Elsewhere in the euro zone, Italy’s economy sank into recession after two consecutive quarters of contraction in its GDP.  The economic trouble in Italy is reflected in the iShares MSCI Italy ETF (EWI) chart shown below. 

The MSCI France ETF (EWQ, not shown) is also reflecting weakness within France.  Meanwhile the former star of the last global economic crisis two years ago ago, namely Greece, is once again showing signs of weakening.  The Greece 20 ETF (GREK), a proxy for the country’s stock market, recently plunged to a new low for 2014.  The financial press hasn’t yet begun to focus on Greece, but it would appear that several countries in the European Union are struggling with economic problems.  The last vestiges of the longer-term deflationary (Kress) cycle are in evidence right now as the 60-year cycle is scheduled to bottom in late September/early October. 

To date the rally in gold futures price has beaten gains made in equities, Treasuries and commodities, according to a Reuters report.  Indeed, many commodity prices have taken a beating this summer as the deflationary cycle nears its terminus.  Corn and wheat prices are at multi-year lows while oil and gasoline prices have recently begun to retreat.  Treasury prices are on the rise as anything with safe haven quality has been the focus of investors’ attentions lately as the long-wave deflationary cycle makes it final curtain call.

By contrast silver was lower on Thursday and continues to lag the yellow metal as safety concerns fuel gold’s latest rally.  Silver is likely to continue its position of relative weakness as long as the climate of investor fear remains the driver for gold.  Only when fear subsides does silver typically see increased demand due to its greater exposure as an industrial metal.

My contention over the last several months has been that as the 60-year cycle of deflation nears its final low this autumn the gold price would likely benefit from it.  We’re beginning to see an uptick of interest in gold as now that fear has taken the front seat again in the news.  Until recently investors cheered all the positive economic news that came out while ignoring bad news pertaining to Russia/Ukraine and the Middle East.  Now good news is routinely ignored while bad news is amplified by investors, a tell-tale sign of a fear-driven market as the long-term cycle bottoms.  A further acceleration of fear should serve to increase investors’ interest in gold.

Let’s once again turn our attention to the investor sentiment picture.  Last year’s decline in the gold price was blamed in large measure on ETF managers dumping physical gold from their funds.  According to a recent report from Commerzbank, ETFs have repeated this action through much of this year.  Commerzbank observed:

Over the year so far on balance, there has still been an outflow of some 30 tons of gold from ETFs.  In view of the headwinds presented by additional demand components, [any] ETF inflows will probably merely have slowed down the price decline in recent weeks.”

The bank emphasized that while gold prices may have been somewhat stabilized by last month’s ETF inflows, it doesn’t foresee a revival in the gold price anytime soon: 

“While the present negative factors remain – a strong US dollar, weak physical demand in Asia, and weak coin sales in the west – we do not envisage any serious price gains.  In addition to modest coin sales in the US, Australian coin sales too, for example, dipped sharply month on month in July to 25,100 ounces.”

Thus another major bank has joined the ranks of the gold bears in what could be setting up another contrarian play for gold.  Adding to the contrarian factor is the behavior of small speculators of late.  According to Barron’s, speculative investors have been cutting back on Comex gold futures and options.

Meanwhile, the latest data from the SPDR Gold Trust (GLD), the world's largest gold-backed ETF, showed that holdings fell 1.79 tons to 800.05 tons, according to Reuters.  This marks the first drop since July 24.  Thus we see that even ETF managers are once again turning bearish on gold. 

The overall sentiment backdrop that is forming is gradually changing more in gold’s favor.  An ideal market environment is one where most retail traders and institutional investors are bearish on the metal, which in turn sets up a potential technical rally as short interest increases.  If the fuel (i.e. bearish sentiment) for the next gold technical rally is ample enough, it could go beyond a simple technical bounce to something more extended.  

Friday, August 1, 2014

Bubbles, bubbles everywhere?

To hear some analysts talk, you’d think the entire financial market was just one gigantic bubble waiting to implode.  Even mainstream media outlets are on full bubble alert with mention of the word “bubble” being mentioned in news headlines on almost a daily basis.  Here’s a collection of recent headlines from blog postings and news sites:

“Bubbles, Bubbles Everywhere”
“The Implosion is Near: Signs of the Bubble’s Last Days”
“When Bubbles Become Manias: The Psychology of Runaway Markets”
“Are Speculative Bubbles Good?”
“Janet Yellen and Bubbles”

Analyst and financial commentator Sy Harding made a good point in a recent edition of his newsletter.  He points out that the U.S. experienced two unusual bubbles in the first eight years of the new century, viz. the Internet stock bubble in 2000 and the housing bubble in 2006.  As Harding points out, before 1999/2000, most investors were probably unfamiliar with the concepts of a financial market bubble.  Yet now, after two back-to-back implosions, everyone sees bubbles even when they don’t exist.  Clearly the historic events of the last 14 years have left a deep scar on investors’ collective psyche – a scar that has yet to heal. 

As Harding mentions in his newsletter, investors frequently use the concept of a bubble as a risk assessment tool.  The “logic” behind this thinking goes something like this:  “If we can determine the market is in a bubble we can get out because it’s due for a serious collapse, but if we can determine it’s not in a bubble we can be assured the bull market has several more years to go.”  Harding rightly points out the fallacy of this thinking, not to mention the potential pitfalls it involves.

Harding writes that there have been 25 bear markets in the last 113 years for an average of one every 4.5 years.  The average decline of these bear markets was 36.5% with the ten worst ones averaging a decline of nearly 50%.  “How many of those serious bear markets were the result of the market being in a valuation bubble that burst?” he asks rhetorically.  Answer: 1929 and 2000.

“Bear markets begin,” writes Harding, “as did the 2007-2009 bear, not due to bubble-level valuations being reached and then bursting, but in anticipation of a slowing economy and potential recession or financial crisis (domestic or global), rising inflation, rising interest rates, global events, or just because the bull runs out of energy.  At those times, stocks are usually overvalued, but not to anywhere near bubble proportions.”

As Harding points out, the market has achieved bubble conditions an average of perhaps once or twice in a lifetime.  By contrast, stock market corrections of 10% to 20% an average of once a year, and a serious bear market occurs an average of once every 4.5 years.  As Harding concludes from this study, it’s time to “cool down the bubble talk” as whether or not we’re in a bubble has little bearing on the level of market risk or whether or not a bear market will occur.